Tuesday, June 28, 2011

The European Commission has launched a consultation on new regulations for venture capital funds. Venture capital is an important source of financing and support for innovative small and medium-sized enterprises that encounter difficulties in accessing bank loans or listing on stock exchanges. The proposal outlines the broad contours of a European passport for venture capital funds so that they could raise capital freely throughout the EU from professional investors and invest in innovative companies. Once the passport had been obtained upon registration in one Member State, the fund manager could then operate throughout the EU without having to register in each Member State where it wanted to raise capital, as is often the case today.

The Commission emphasized that the fragmentation of markets for venture capital is an issue that requires immediate action. The immediate priority is to enlarge the geographical base in which venture capital funds can raise and invest capital. The Commission's goal is to achieve a real internal market for venture capital funds in the EU and reduce tax barriers to the greatest extent possible.

In this way venture capital funds would benefit from economies of scale and specialized sectoral expertise would emerge. This situation would have a number of positive consequences, said the Commission, such as more and bigger venture capital funds able to provide capital to a greater number of small and medium-sized enterprises.

Managers of venture capital funds are covered by the Directive on Alternative Investment Fund Managers, noted the Commission, since venture capital falls under the generic category of alternative investment. Therefore, managers of venture capital funds with assets under management above EUR 500 million can benefit from the European passport provided by the Directive. Managers under that threshold do not benefit from the Directive passport unless they decide to make use of the opt-in procedure envisaged in the Directive, in which case they have to comply with the full set of obligations and requirements of the Directive.

In order to provide legal certainty, the interaction of the new regime on venture capital with the AIFMD would be clarified. There are two options to do this. The first one is to exempt from the AIFMD only those managers that are below the threshold of the Directive. The second option is to exempt from the scope of the AIFMD the managers that fall under the new venture capital regime even if they trespass the thresholds of the Directive. In any event, the managers falling within the scope of the new venture capital initiative should exclusively manage venture capital funds investing in small and medium-sized enterprises.

Since investment in venture capital implies a certain level of risk, said the Commission, it is generally not considered a suitable investment vehicle for retail investors. Therefore, venture capital funds covered by the proposed European passport system would only be offered to professional investors as defined by MiFID. As a consequence, venture capital funds that would operate under the proposed passport system would not be obliged to face the traditional disclosure obligations and requirements linked to investor protection, which would imply an offer to retail clients.

Thus, the Commission envisions that venture capital investors would be professional and would apply high standards of due diligence, while undertaking a thorough examination of any fund before they decide to make an investment. These investors are expected to closely monitor the activity of the manager of the venture capital fund and the evolution of their investments.

Under the proposal, venture capital managers would only be required to produce an annual report including the annual financial accounts and a report of the activities of the financial year for each fund, and this report would be made available to investors and competent authorities. The financial information would be audited. The proposal would not include any other specific information requirements to investors, since the information for investors will follow industry standards and will be specified in the fund rules or instrument of incorporation of the venture capital fund.

It will be difficult but essential to get the definition of venture capital fund right, said the Commission. The proposed European passport will be conditioned on the definition, noted the Commission, as well as possible tax benefits that Member States might design for this type of investment. The Commission will approach the definition from a number of inclusionary and exclusionary paths involving fund activities and investment strategies. For example, the Commission envisions defining a venture capital fund as an entity that invests in small and medium-sized enterprises with growth potential that are in the first or very early stages of development or expansion. More precisely, it seems appropriate to concentrate the legislative initiative on venture capital funds that invest in either seed, start-up or expansion stages.

Definition by exclusion is based on the rationale that there are some types of investments which per se do not fit into the notion of venture capital helping to develop small and medium-sized businesses. In particular, it is not appropriate to allow venture capital funds who wish to benefit from the EU regime to invest in companies that are traded on a secondary market, in financial entities, other funds or financial instruments.